What is the real inflation rate for energy?

There’s been a lot of coverage of increasing energy bills in the media in recent months. Also I’ve been doing a bit of thinking about the return on investment for solar thermal under the imminent domestic renewable heat incentive. (I like writing ‘imminent’ instead of ‘forthcoming’!)

It turns out that the assumptions you use for the rate of fuel price increases can have a dramatic impact on the rate of return from an investment in renewable energy generation technologies such as biomass, heat pumps, solar PV and solar thermal.

So what is the inflation rate for energy? It turns out to be surprisingly difficult to get an answer to this question.

So I had to do some rooting around of my own. The full description of my analysis can be found in this article at the solarblogger, but here’s a summary.

The past as a guide to the future

I used data collected by the Office for National Statistics in compiling the Consumer Prices Index (CPI). The most recently published data range covers the fourteen years from 1998 to 2012.

The chart below shows the change in costs with 1998 prices set to 100.

General inflation (consumer price index) increased costs by 37% over the whole for the fourteen-year period. It can be seen that all energy costs have risen by more. Electricity has risen by 100% in the same time, gas by 195% and heating oil by 428%.

What you can also see on the graph is that prices have not risen steadily. In particular fuel oil prices are volatile. They fall back before rising steeply again.

Your measure of fuel inflation is very much affected by the choice of start and finish date. This is a fact that is often used by those who want to present a biased picture in one direction or the other.

For example choosing a period from 2000 to 2009 produces a real inflation rate (the increase to energy price over and above general price increases) of “only” 4.7% a year for heating oil, whereas selecting 1998 to 2008 yields a wallet-busting 14.3%.

So how to choose a ‘fair’ period? Well, what I chose to do instead was to calculate the inflation rate for all periods in the data (every possible start and finish date) and then calculate an average.

This approach produces a real rate of inflation of 2.8% for electricity, very close to the figure of 2.6% used by DECC for forecasting future price changes of electricity.

The analysis was repeated to produce a real rate of inflation of 5.8% for gas and 8.5% for heating oil.

I haven’t been able to find any similar data on the cost of biomass (e.g. pellets), but would be very interested to repeat the analysis if anyone knows a source.

Heating fuels have risen much faster than electricity. Why is this?

The cost of gas or heating oil delivered to your home is made up almost entirely of the cost of the wholesale price of the fuel (with a little extra for transport).

By contrast, our electricity bills are made up of the cost of the primary energy (coal, gas, oil), but also the very significant cost of building and running the power station plus the cost of transmission to your home. Add in the ‘green levies’ and you can see that a rise in wholesale energy costs won’t be so strongly represented in electricity bills. In addition electricity generators can respond to increased prices in one fuel by changing their generation mix (for example as has been happening recently with the substitution of gas generation with coal).

These figures for inflation of energy costs will be helpful to customers considering investing in any kind of renewable energy, but if you're being shown financial information by a potential supplier, do remember to ask what inflation rate for energy that they have assumed